The Impact of Auto-enrollment and Automatic Contribution Escalation on Retirement Income Adequacy

NEW SIMULATION MODEL: This Issue Brief expands upon earlier work by EBRI to provide the first results of a new simulation model that estimates the impact of changing 401(k) plan design variables and assumptions on retirement income adequacy. Previous research has demonstrated the large potential impact of auto-enrollment (AE) on retirement income adequacy. Until recently however, there was extremely limited evidence on the impact of automatic contribution escalation. This study is part of a larger joint project between Employee Benefit Research Institute (EBRI) and the Defined Contribution Institutional Investment Association (DCIIA).

METHODOLOGY: The definition of “success” for this analysis is a situation that produces a combined real replacement rate from Social Security and 401(k) projected balances of at least 80 percent. The analysis is limited to younger employees (with 31–40 years of 401(k) eligibility) and provides separate results for employees in the highest- and lowest-income quartiles. Using this definition of success, the model is used to determine how success changes with:

• The maximum level of employee contributions allowed by the plan sponsor (6, 9, 12 and 15 percent of compensation).

• The annual increase in contributions (1 vs. 2 percent of compensation). • Whether employees are assumed to opt out of the automatic escalation.

• Whether employees are assumed to remember/retain their previous level of contributions when they change jobs vs. reverting back to the plan’s initial default.

IMPORTANCE OF 401(K) PLAN DESIGN FACTORS: The results in this paper demonstrate the profound influence of plan design variables, as well as assumptions of employee behavior in auto-enrollment 401(k) plans. Even with a relatively simple definition of “success,” large differences in success rates can be seen, depending on which plan design factors and employee behavior assumptions are used:

• The probability of success for the lowest-income quartile increases from the baseline probability of 45.7 percent to 79.2 percent when all four factors are applied.

• The impact on the highest-income quartile is even more impressive, with an increase in the probability of success from 27.0 percent to 64.0 percent.

WORKER CONTRIBUTIONS A KEY FACTOR: When viewed in isolation, it is clear that the impact of increasing the limit on employee contributions is much greater than any of the other three factors. However, the importance of including one or more additional factors, along with the increase in the limit on employee contributions, can more than double the impact of increasing the limit by itself.